Arista Down 6% as ITC Sides With Cisco: Bulls Unfazed; Will Workaround Work?

By Tiernan Ray

Shares of Arista Networks (ANET) are down $3.07, or 4%, at $70.75, recouping some of its earlier pre-market losses, which had the stock down 8% or so, following an adverse ruling yesterday by the International Trade Commission in the company legal battle with Cisco Systems (CSCO).

There are no ratings changes today, that I can see, perhaps because the adverse ruling had been expected by some Arista bulls, such as Citigroup’s Stanley Kovler, who on Wednesday had urged investors to look past a likely import ban on Arista gear. In a fifteen-page followup note this morning, Kovler reiterates his Buy rating, and $75 price target, writing that the product cycles for Arista matter more than legal issues.

Cisco shares are falling with the broader market, down 87 cents, or 3%, at $28.35.

Arista said in a statement that the ITC issued a “cease and desist order” for three Cisco patents, in investigation number 337-TA-944, commonly referred to as the ‘944 Investigation. Arista noted the order is to be reviewed by U.S. trade reps.

Arista reiterated that it has built “work-arounds” into its “EOS” operating system software.

It also took a swipe at Cisco, with general counsel Marc Taxay stating:

Despite Cisco’s rhetoric claiming that the lawsuits are a defensive move to protect its intellectual property, these actions are clearly part of a broader effort to use litigation to preserve Cisco’s market position. If allowed to succeed, Cisco’s scheme would have a chilling effect on innovation. While we will defend our rights in these actions, our primary focus remains on the continued supply of products to our customers.

Cisco’s chief counsel, Mark Chandler, took a victory lap in a blog post, writing that the ruling “marks the end of Arista’s ability to mislead its shareholders and customers about the infringing nature of their products.”

Chandler thinks Arista is wrong to request the full text of the final ruling be redacted in large parts:

The Commission’s own full decision will be issued shortly. Arista insisted that large portions of Judge Shaw’s opinion be kept secret. Cisco is prepared to allow all but six lines of that opinion, which incorporate customer information, to be made public. We call on Arista to be honest with its shareholders and customers about the scope and intentionality of its misappropriation by allowing Judge Shaw’s opinion, and the ITC’s pending decision, to be made public.

The response from Street bulls is fairly calm, as I said. Kovler, in his note today, writes that the Street probably hasn’t yet taken into account the drag on Arista margins:

With Arista starting to manuf. products in the US in 2H’16 we do not believe that Street gross margin estimates for 2H’16 reflect the impact of startup costs and mgmt. GM guidance of “lower 60s” in 2H’16. We model GM of 62.9% in CY16, down 240 bps y/y from 65.3% in 2015 on 62% 2H’16 GM vs. Street of 63.5% that could have downside risk particularly if Arista need to rely more heavily on US manufacturing in the event of an extended customs approval process gross margins could actually approach closer to 60% temporarily.

Arista still has to face off against Cisco in a second case of infringement, coming in August, Kovler notes: Arista is also taking its grievances to the US Patent Office and asking the USPTO to invalidate several Cisco patents. Although these actions may not have any effect on the ‘944 case, it could potentially aid its position in the ‘945 case against Cisco that begins in late August.

He offers the following helpful calendar of upcoming legal dates (click on the image to see it larger):

As for what Arista could be on the hook for longer term, he sees $600 million if Cisco were to get treble damages ultimately:

Using a similar case from the Juniper / Palo Alto dispute that was finally settled in 2014 with $175M in damages awarded to Juniper, which was asserting its patents against Palo Alto. In a best case scenario, continued litigation eventually leads to a $150M award for Cisco, but more likely closer to $600M if we add in 3x punitive damages. We are making that leap because if Arista is implementing workarounds by mid-late 2016, it will not be required to pay future royalties to Cisco, which would obviously increase the damage award.

Arista’s plan to ramp up manufacturing in the U.S., to get around an import ban, should decrease its gross profit margin by 1 to 2 points, he estimates.

This is not going to be a long-term issue for Arista, he writes:

OK, there is some incremental cost on the GM line for inventory and CMS redundancy for a number of quarters. And yes, there is still uncertainty on the second set of patents. But we view these costs as a quasi-one-time item, which after a period of time will fall back out. Further, we think ANET will be to deliver full workarounds on the first set of patents, and we think the second tranche will follow the same pattern. We do not expect these patents to be a meaningful issue for ANET long term.

Credit Suisse’s Kulbinder Garcha, who has an Outperform rating on Arista and an Underperform rating on Cisco, sees little impact on Arista given workarounds, and “a prolonged battle ahead, with limited impact so far on companies and industry fundamentals.”

Cisco’s still got the same problems it has always had, he thinks:

Given the infringement on the three patents, Cisco can rightfully claim some victory and believe they have bring damage to Arista brand as a result. We do note, however, while Cisco commands an absolute market position in Networking, it has been losing share to Arista, and is increasingly disrupted by the SDN trend. We believe this victory does not materially alter its business outlook.

Nomura’s Jeffrey Kvaal, who has a Buy rating on shares of Arista, writes that even though the company has “well-rehearsed contingency plans,” nevertheless, “we expect this case, heretofore a theoretical headwind, to begin to impact Arista’s financials.”

The impact will be on profit, not sales, he expects:

The most direct impact to Arista’s income statement should be a gross margin reduction of ~300bps associated with US contract manufacturing. We do not believe Arista is facing incremental revenue challenges just yet. • Margin degradation may offset expected revenue upside. We believe consensus 2016/2017 revenue growth expectations of 30%/20% are too conservative; we model 32% and 25%. Conversely, the consensus 2017 EPS estimate of $3.25 appears to embed only half of the expected 300bps gross margin impact. Our higher sales estimates would add ~$0.15 to consensus, the lower gross margin would subtract ~$0.15.

Steve Milunovich with UBS, who has a Neutral on the stock, writing that the company is not out of the woods yet: it now has the “burden of proof” to convince regulators its workaround is acceptable:

Arista says that a software fix for the 944 case has been released in the form of a new network OS. However, the burden of proof is now on Arista, and it must get the fix approved before August 22, which marks the end of the Presidential review period. If it takes longer or if the fix is still found to be in violation of the patents, Arista would not be able to import its products into the US. Arista recently engaged a new contract manufacturer to make its products domestically, which includes all components. While Arista should be able to source everything domestically for the time being – helped by a likely inventory build-up – we think the outcome of the workaround solution is key. We believe margin pressure could be material in 4Q as a result of the shift to sourcing domestically. We see the worst case scenario of most production shifting to the US being a gross margin decline to near 60% vs the current 64-65% range (link).

About Tech Trader Daily

Tech Trader Daily is a blog on technology investing written by Barron’s veteran Tiernan Ray. The blog provides news, analysis and original reporting on events important to investors in software, hardware, the Internet, telecommunications and related fields. Comments and tips can be sent to: techtraderdaily@barrons.com.